Other Ways to Analyze a Company’s Valuation

A completed Stock Selection Guide is filled chock to the brim with numbers. Numbers are convenient and unambiguous. But they reflect human activities. A company’s reported sales, profit margins and stock price come from business ideas and decisions, like the founders’ novel ideas, a board of directors’ policies, the leadership abilities of executives and the hard work of its employees.  

It’s difficult to measure the strength of an idea and the talent of a management team, nor can we assign a dollar value to company culture. We still need to try. Those hard to measure properties are what we’re really investing in. There’d be no Tesla without Elon Musk, no Amazon without a Jeff Bezos and no Post-It Notes without the culture of innovation at 3M. Also, customer preferences and the economy can changeon a dime. Companies that can’t adapt will fail and will take their stockholders’ wealth with them.

A Case Study: When Apple Was Almost a Lost Cause

Once upon a time (1976), two college dropouts decided to make a computer user friendly enough to be bought by typical consumers instead of hobbyists who spoke fluent hexadecimal. This computer, the Apple I, didn’t have a keyboard or a monitor (or even a case), but the second iteration did and displayed in color to boot. Apple II sales exploded, reaching $117 million in 1980. 

​One of the two founders, Steve Wozniak, stepped away from the daily operations of the com­pany. After a couple of years, the remaining founder, 28-year-old Steve Jobs, set out to find a CEO who could provide his company desperately needed executive skills and marketing savvy.

​Enter John Sculley in 1983. Sculley was recruited to Apple while he was the CEO of Pepsi. Jobs offered to double his compensation and asked him whether he wanted to “sell sugar water for the rest of his life or come with [him] and change the world.” At first, Apple thrived, but that was largely because of projects that were already in the works, such as the legendary Macintosh computer. But the relationship between Sculley and Jobs soured and Jobs’ attempted ouster of Sculley led to Jobs’ departure. 

​Without Jobs, the company floundered. Apple’s innovative but expensive Newton personal digital assistant flopped. Having already passed up a potentially lucrative licensing opportunity with Microsoft, Apple tried licensing its operating system to other computer makers to get a quick influx in revenue but surrendered its consumer-friendly advantage. 

​Sculley, along with IBM and Motorola, also attempted to overthrow Intel’s dominance in chip manufacturing by shifting to the PowerPC chip, only to find that Intel’s scale and manufacturing expertise could easily fend off competition. Intel’s Pentium series leapfrogged the PowerPC in performance, Apple sales suffered. Sculley resigned as CEO in 1993 when Apple made only $83 million in profit  .Apple continued to struggle until its board lured Steve Jobs back. The rest is history.

Numbers Trail Decisions

When analyzing stocks, we over­emphasize trends. Earnings that have consistently grown at some rate aretypically forecasted to continue at that same rate. Chief financial officers pull every accounting lever they have to ensure profit growth appears consistent, as consistent growth leads to higher stock valuations. Sooner or later, though, accounting legerdemain gives way to economic reality. That’s why it’s just as important to evaluate the company away from the numbers as it is to review the financial statements and value the stock.

​Here are five key dimensions to help you develop a qualitative assessment of a stock before you invest or even complete an SSG.

Do you understand the business?

Here’s some wisdom from Warren Buffett, the Oracle of Omaha: Don’t invest in a company you don’t understand. Though that made him late to the game with tech stocks, it also prevented him from investing in some famous disasters like Enron. 

​Some companies are easy to grasp.WD-40 Company (ticker: WDFC) produces specialty chemicals. Its profit is driven by sales and cost of goods sold. Management specifically referenced fluctuating petroleum product prices in the latest quarterly report, and given that its namesake product is a lubricant, that makes perfect sense.

​Conglomerates are far more challenging. General Electric is involved in aviation, energy, power and health care and that’s after the company divested itself of an even more bloated portfolio of businesses. It’s hard to imagine why individual investors would buy GE stock unless it’s based on an almost blind faith in management’s abilities.

​There’s a caveat to only investing in easily understood stocks. You not only need to be able to understand where the profit comes from. You also should know how it keeps an edge or lid on competition and how it intends to keep it.

What is the company’s competitive strategy?

Firms can compete on quality, convenience, cachet, innovation and price. They can be successful using any one of these strategies. You can assess how well they’ve been executing by comparing their profit margins to competitors. If their profit margin is high, the company has been successful.

​The question will always be whether that will continue? That requires monitoring the competition and needs of its customers. Want to know who didn’t pay attention? America Online, who held steadfast to dial-up modem revenue and watched its competition eat its lunch. AT&T, too, was slow to abandon its copper wire network and had to scramble to reinvent itself. Blockbuster could have been a pioneer of streaming media but is now only remembered for the “Be Kind, Rewind” stickers on its videotapes. Oops.

​Companies pursuing a low price strategy maintain razor-thin gross profit margins in exchange for high sales. The two challenges to that approach will be maintaining the sales volume necessary to pay for all the fixed costs and managing all costs efficiently. Airlines are the poster children for price competition, high fixed costs, variable costs and consumer demands. 

​Firms can rarely compete effectively if they pursue more than one strategy. If and when they do, they often establish separate brands. Should you see a company applying conflicting strategies to its core business, there’s likely a lack of focus or a sense of desperation floating around the C-suite. Expect turmoil in the near future.

How does the firm grow?

Ideally, businesses should be able to grow through making their products and services ever more desirable. But even the most successful products mature and eventually decline in sales as competitors catch up. Executives are acutely aware of the need to replace lost revenue and the imperative to grow. Shrinking companies lead to shrinking career prospects.

​Successful innovators don’t need to make acquisitions to grow. They might scoop up a firm when the opportunity is too compelling to ignore. Otherwise, they tend to do best focusing on their core busi­nesses and markets.

​Investors should be very skeptical of any firm that grows through acquisitions, especially when those acquisitions are outside of its core expertise. First, acquisitions occur at a premium to the market value of the target firm. If the firm’s shareholders wanted it before, they would have bought the target’s shares already.

​Executives often justify their acquisitions by touting synergies that would accrue to the newly merged firm but all too often those synergies often fail to materialize. For example, on May 17, AT&T (T) announced it was merging its media assets associated with WarnerMedia with those of Discovery, Inc. (DISCA). 

​One of the reasons cited in an AT&T press release announcing the divestiture was that it would allow AT&T to focus on its core business of broadband and wireless connectivity. Only four years ago, AT&T and Time Warner referred to combining the two entities as “best in class assets in [the] converging media and communications industry.”

What are employees saying about the company?

Keeping employees happy won’t automatically lead to higher share prices, but employee turnover is expensive and could be a warning sign of even bigger issues. Glassdoor is a website that shares employees’ candid reviews of their employers. If you’re willing to read through many reviews of varying quality, there can be some critical insight into whether the company is pointed in the right direction or headed down the tubes. Some of the most valuable perspectives come from contractors with broad experience across their industries.

Who runs the company and how are they paid?

Corporate governance sounds like the dullest of topics, but it covers whether a company is run for the benefit of its executives or the benefit of its owners. Founders are often reluctant to relinquish control of their creations but were better suited to be entrepreneurs instead of managers. 

​Family-owned businesses might delegate responsibilities and compensation to family members to the disadvantage of minority shareholders, who will have little say in how the company is run.

​Problems tend to arise when the boards of directors are too aligned with the managers they hire. A board’s primary roles are to approve strategic decisions (such as acquisitions and paying dividends), hire a chief executive and ensure shareholder wealth is being maximized. 

​If a CEO holds too much sway over the board, then there aren’t enough checks on the CEO’s decisions and compensation. Ideally, the CEO will not simultaneously be the chair.

​Compensation should be aligned with maximizing shareholder wealth along with the market for top executive talent. If executives are paid solely by salary, they will have little financial incentive to lift the stock price. 

​Nor should pay be tied entirely to short-term results such as quarterly earnings. The pay should offer balanced incentives for stock performance and the long-term financial health of the company. Usually that’s done by paying executives in stock that vests after a period of time.

Valuation Still Matters

After the overheated markets of the past decade, it’s often tempting to skip the financial analysis and just go with your impressions of what a firm does or how you think the latest headline will affect the stock price. But once the market starts hitting extremes, that’s when there’s more downside risk in even the best of companies. 

​That’s why completing the Stock Selection Guide sheets should continue to play a critical part in your stock analyses. The sort of qualitative analysis in this article might tell you whether or not the company is solid, but the SSG will give you a basis on whether it’s an attractive investment.

This article was originally published in the September 2021 issue of BetterInvesting Magazine.

Securities mentioned are illustrations or for study and presented for educational purposes only. They are not to be considered as endorsed or recommended for purchase by NAIC/BetterInvesting. Investors should conduct their own review and analysis of any company of interest using the  Stock Selection Guide before making an investment decision. Securities discussed may be held by the writer in his personal portfolio or those of their clients.  

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